490 CHAPTER 13 Capital Structure Decisions
Thus it appears as though the presence of personal taxes reduces but does not com-
pletely eliminate the advantage of debt financing.
Trade-Off Theory
MM’s results also depend on the assumption that there are no bankruptcy costs. How-
ever, in practice bankruptcy can be quite costly. Firms in bankruptcy have very high
legal and accounting expenses, and they also have a hard time retaining customers, sup-
pliers, and employees. Moreover, bankruptcy often forces a firm to liquidate or sell
assets for less than they would be worth if the firm were to continue operating. For ex-
ample, if a steel manufacturer goes out of business, it might be hard to find buyers for
the company’s blast furnaces, even though they were quite expensive. Assets such as
plant and equipment are often illiquid because they are configured to a company’s indi-
vidual needs and also because they are difficult to disassemble and move.
Note, too, that the threat of bankruptcy,not just bankruptcy per se, produces these
problems. Key employees jump ship, suppliers refuse to grant credit, customers seek
more stable suppliers, and lenders demand higher interest rates and impose more
restrictive loan covenants if potential bankruptcy looms.
Bankruptcy-related problems are most likely to arise when a firm includes a great
deal of debt in its capital structure. Therefore, bankruptcy costs discourage firms from
pushing their use of debt to excessive levels.
Bankruptcy-related costs have two components: (1) the probability of financial dis-
tress and (2) the costs that would be incurred given that financial distress occurs. Firms
whose earnings are more volatile, all else equal, face a greater chance of bankruptcy
and, therefore, should use less debt than more stable firms. This is consistent with our
earlier point that firms with high operating leverage, and thus greater business risk,
should limit their use of financial leverage. Likewise, firms that would face high costs
in the event of financial distress should rely less heavily on debt. For example, firms
whose assets are illiquid and thus would have to be sold at “fire sale” prices should
limit their use of debt financing.
The preceding arguments led to the development of what is called “the trade-off
theory of leverage,” in which firms trade off the benefits of debt financing (favorable
corporate tax treatment) against the higher interest rates and bankruptcy costs. In
essence, the trade-off theory says that the value of a levered firm is equal to the value
of an unlevered firm plus the value of any side effects, which include the tax shield and
the expected costs due to financial distress. A summary of the trade-off theory is ex-
pressed graphically in Figure 13-3. Here are some observations about the figure:
1 .Under the assumptions of the Modigliani-Miller with-corporate-taxes paper, a
firm’s value will be maximized if it uses virtually 100 percent debt, and the
line labeled “MM Result Incorporating the Effects of Corporate Taxation” in
Figure13-3 expresses the relationship between value and debt under their as-
sumptions.
2 .There is some threshold level of debt, labeled D 1 in Figure 13-3, below which the
probability of bankruptcy is so low as to be immaterial. Beyond D 1 , however,
bankruptcy-related costs become increasingly important, and they reduce the tax
benefits of debt at an increasing rate. In the range from D 1 to D 2 , bankruptcy-
related costs reduce but do not completely offset the tax benefits of debt, so the
stock price rises (but at a decreasing rate) as the debt ratio increases. However, be-
yond D 2 , bankruptcy-related costs exceed the tax benefits, so from this point on
increasing the debt ratio lowers the value of the stock. Therefore, D 2 is the optimal
capital structure. Of course, D 1 and D 2 vary from firm to firm, depending on their
business risks and bankruptcy costs.
486 Capital Structure Decisions
